FED FOCUS-'Fiscal cliff' makes U.S. Fed queasy

Tue Apr 24, 2012 1:52pm EDT

Related Topics

* Election-year politics could undermine Fed policies

* Big tax hikes, spending cuts scheduled for year end

* Bernanke could emphasize risks to Congress on Wednesday

By Jonathan Spicer

NEW YORK, April 24 (Reuters) - Federal Reserve policymakers are sounding the alarm over a "fiscal cliff" at the end of this year, when scheduled U.S. tax hikes and spending cuts could pose a big threat to the fragile economic recovery.

Along with its official mandate of watching unemployment and inflation, the U.S. central bank is keeping a close eye on a potentially debilitating political fight over how to fix the budget deficit.

If lawmakers in Washington do not get rid of the tax hikes and spending cuts due to take effect in early 2013, the country could easily careen into another recession. Any moves by Congress, however, aren't expected until after the Nov. 6 presidential election.

The Fed is worried that individuals and companies could hunker down and curb spending, making markets antsy as the country awaits the outcome of an election that could pave the way for new tax and spending policies.

Though few expect Washington to do nothing while fiscal policies push the economy into another downturn, partisan politics could undermine the Fed's unprecedented actions to revive the economy.

"I have been disappointed that the president and Congress are not taking action until after the election," St. Louis Fed President James Bullard told reporters in Utah last week.

"I'm also worried that markets will react badly to the fiscal cliff at the end of this year. Markets might start to speculate about what might or might not happen ... after the election," he said.

Asked what the Fed can do, however, Bullard seemed to dismiss the possibility of resorting to new bond buying to counter the effects of political gridlock over the budget deficit and economic policy.

"It's up to the Congress," he said.

Lawmakers pushed the United States close to a debt default in a bruising 2011 debate over raising the debt ceiling, roiling markets and costing the U.S. its top credit rating from Standard & Poor's.

This time, even more is at stake, and time is running out.

'MASSIVE' CLIFF

The so-called Bush tax cuts expire at the end of 2012 -- which means nearly all U.S. taxpayers would have to pay more taxes unless the cuts are extended.

At the same time, $1.2 trillion in across-the-board reductions in federal programs would kick in as a result of Congress's failure last year to find a comprehensive deal to cut the budget deficit.

The U.S. is expected to again hit its debt ceiling, or legal borrowing limit, by year end, which means Congress will need to agree to increase the ceiling or parts of government could ground to a halt.

On top of that, U.S. President Barack Obama's payroll tax cut to 4.2 percent from 6.2 percent also expires Dec. 31, and another patch is needed to prevent the alternative minimum tax (AMT) from affecting more middle-class families. The AMT was originally aimed at just the wealthy but now establishes a minimum tax rate for an increasing number of middle-class taxpayers.

The issues are likely to be dealt with in the "lame duck" Congressional session between Election Day and the new year, leading to a frenzied few weeks. But the uncertain backdrop of who will occupy the White House and Congress in 2013 has created even more worry.

"We're naive if we think that doesn't play into the Fed's thinking about monetary policy," said Tom Porcelli, chief U.S. economist at RBC Capital Markets in New York.

"But the way that the Fed would want to present it is a minor consideration at best, because they don't want to be supplementing fiscal policy," Porcelli said.

Fed officials gathered for a policy meeting on Tuesday, and Chairman Ben Bernanke could use a Wednesday press conference to warn lawmakers just how dangerous the situation could be.

In February, Bernanke told Congress the U.S. recovery could derail if lawmakers failed to address the "massive" fiscal cliff.

"I hope that Congress will look at that and figure out ways to achieve the same long-run fiscal improvement without having it all happen at one date," he said.

If the brewing crisis goes unaddressed, RBC Capital Markets forecasts, U.S. GDP growth could be reduced by 3.8 percentage points at a time when the economy is expected to grow by little more than 2 percent.

PLEADING FOR A PLAN

Fed policymakers have suggested the economy would have to deteriorate from forecasts and inflation remain low for the Fed to take more steps, including a third round of bond buying, or quantitative easing (QE3).

Since late 2008, the central bank has kept interest rates near zero and bought $2.3 trillion in securities to spur growth and support the recovery, which has been bogged down by frustratingly high unemployment and tepid growth.

Fed officials regularly plead for a credible fiscal plan from lawmakers that lowers U.S. debt without sharp, short-term spending cuts and tax increases that would curtail investment and spending and undercut the recovery.

"One specific risk is that elevated uncertainty about prospective fiscal policy adjustments could weigh on the spending plans of households and businesses," Fed Vice Chair Janet Yellen said this month.

U.S. consumer sentiment remains fragile, slipping this month as Americans were less optimistic about the short-term outlook. Consumers and investors alike could become preoccupied with the fiscal uncertainty if it appears little will get done until after the election.

"Certainly if you listen to the Republican platform, this would be a very different set of policies, and people may be uncertain about that, and may indeed pull back on spending," said Avinash Persaud, chairman of London- and Mumbai-based investment bank Elara Capital.

Last August, uncertainty over the U.S. debt ceiling sparked daily triple-digit swings in the Dow Jones industrial average , which fell 7.2 percent over two weeks while investors sought safety in bonds.

Today, with rates so low and credit readily available, the effects of any additional Fed steps to head off such turmoil could be limited. And conservatives would likely criticize any Fed action as interfering in an election in which the economy is center stage.

Economists polled by Reuters this month put the odds of more Fed bond purchases at 30 percent. Illustrating the uncertain environment, 11 of 16 primary dealers polled by Reuters said the Fed will eventually embark on QE3.

"You set monetary policy based not just on the economy today, but on where you see the economy going for the next couple of years," said Roberto Perli, managing director of policy research at broker-dealer International Strategy and Investment Group in Washington. "Clearly that puts the fiscal cliff squarely in your sights."

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